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(Not sure if this should be on the Economics SE; however I am interested in both economic & political consequences)

Trump threatens new tariffs on China as US mulls retaliatory action over COVID-19

The Washington Post, citing two people with knowledge of internal discussions, reported on Thursday that some officials had discussed the idea of canceling some of the massive US debt held by China as a way to strike at Beijing for perceived shortfalls in its candidness on the COVID-19 pandemic.

This was later denied by the White House's economic advisor Larry Kudlow, but let's suppose the US actually carries out this plan. What could the consequences be?

My (very naive) understanding of economics is that if a nation defaults on its debt, it will usually cause a depression because the creditors suddenly don't have money anymore. However the creditor in this case is a single external entity, and presumably a depression in China would be less of a concern to the US. Another consequence would be less investor confidence, however if the rest of the world thinks the US remains reliable and is only retaliating for a perceived injustice, then this should again not be a concern. But then again if this is correct, this sounds like an effective way for the US to retaliate, so why would the US not seriously consider this if they're looking for ways to apply pressure (per Larry Kudlow)?

I do not understand it, so I'm hoping someone can clarify: what are the consequences of selectively canceling debt?

Related: What happens if a country becomes bankrupt? which deals with the more general case of defaulting on all debt.

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    I think you’ve got it backwards: it is the borrower, not the creditor that is at risk of a depression. The creditor still has a surplus of money, that’s why they’re lending it. The borrower needs money, but no one will lend it to them if they refuse to pay it back. – divibisan May 1 at 3:40
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    @divibisan, I think the distinction comes down to whether the debt is merely £100, or £1tn. Default on the former, it's the debtor's problem - default on the latter, and it's the creditor's problem. Who suffers is really about the power balance, and what the scale of the debt implies about that balance. It's true that defaults often destroy the market for credit - at least if they are unilateral and capricious - but the need to default suggests the market wasn't working for the debtor anyway. – Steve May 1 at 14:30
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    In this particular example, China would just cease American owned goods, factories, technology and prepayments on services not yet rendered. It would cover the lot, I suspect. The Dow wouldn't appreciate it. – Stian Yttervik May 2 at 0:43
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    @Stepan More importantly, America needs those greenbacks out in the world, because to make this system work they have to be the "buyer of last resort." American hegemony is based on consumer spending, and investor ( via bonds ) confidence. The military's job is to lay waste to any nation who feels, like say, Saddam did, that selling oil in euros makes fiscal sense, given gas prices at the time, make a buck, hurt the enemy, what could go wrong? He died, well, it must be said, but he died. If Canada did the same thing, same result. ISIS filled the gap. Non optimal result. – chiggsy May 3 at 3:19
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    In "however if the rest of the world thinks the US remains reliable and is only retaliating for a perceived injustice, then this should again not be a concern" you may be misjudging the rest of the world perception. I am pretty sure this is a concern. – lvella May 4 at 10:54
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A selective default is rare because its consequences are not that much better compared to a full default:

  • all US assets abroad would be at risk of seizure to cover the debt
  • the US reputation as a borrower will plummet

Both consequences will not be limited to China. For instance, if US has assets in Mexico, China could claim them as compensation for the unpaid US debt towards China. Of course, it will be up to Mexico to decide to honor such claims, but there will be a non-trivial cost for them should they decide to protect US assets, especially if they have business with China as well.

Some assets such as IP are even easier to seize. If China starts selling cheap iPhone clones, Apple will instantly lose a significant share of their business worldwide, not just in China.

This is similar to what will happen if you (as a person) decide to "selectively default" on a loan in one bank while having a positive account balance in another bank, or other assets that can be seized.

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Future lenders know that the borrower doesn't always pay.

They will take that into consideration when they give future loans. More risk-averse lenders will not deal with the unreliable borrower at all, while greedy ones might do so with a risk premium on the interest. That means future credit becomes more expensive.

The Eurozone is a good example because independent countries issue bonds in the same currency. One Euro is one Euro and there are international financial markets, so one might expect that the interest rate is the same for all countries, but it isn't. That's because some Eurozone bonds are seen as more risky than others.

Does that apply to the US?

Maybe. The US economy is so big, and so central to the world economy, that there are no real precedents. Too big to fail, the saying went during the last banking crisis. But look at the example of Argentina. Their default certainly had consequences.

It could well be that the US treasury will find it harder to sell future bonds to anyone. That would lead to pressure on the treasury and a snowballing inability to pay debts to all holders, not just selective ones, and that could hit domestic markets as well. Like pension savings.

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    In addition, if the US decided to default on some of its debts just to punish China, then there is ample scope for retaliation by China against the US and US companies. The US doesnt get to just do it and be untouchable. – Moo May 1 at 6:12
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    If you don't default much debt, then potential bonds buyers consider that you might pay or might not pay, calculate (guesstimate) a chance of you not paying, and factor that into the price they're willing to purchase your bonds for. If you always pay, a bond for $1000 might sell for $950. If there's a small risk you won't pay, a bond for $1000 might sell for $900. If there's a HUGE risk you won't pay (you have a history of defaulting a ton of debt), a bond for $1000 might sell for $100, or might not sell at all. – Blueriver May 1 at 20:02
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    @Blueriver, that is the risk premium. – o.m. May 2 at 4:44
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    Not sure I agree with "greedy ones". If you're charging a risk premium, you are not being greedy, you are simply adjusting the price to account for the extra risk. You're no less and no more greedy than you were before you charged the risk premium, when the risk didn't exist. – JBentley May 2 at 23:50
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Direct Relations with China

China might retaliate. In history delinquent countries have often lost their sovereignty and become colonies or seen their government overthrown (e.g., British Egypt or the (second) French expedition in Mexico). It's probably that China considers its power insufficient for a direct confrontation, but it might decide to challenge the US hegemony in certain regions of the world by openly supporting its enemies and wooing discontent allies (e.g., in the Middle East or Caribbean).

In any case, such an action could have repercussions for generations to come. Neither China nor the US is likely to disappear soon. In 1996 Russia felt compelled to agree to the repayment of debts incurred by Tsarist Russia, which had been repudiated almost 80 years earlier, after the Russian Revolution of 1917.

Formal Consequences of a Selective Default

Such an action should be considered a selective default (as termed by Standard&Poor's) by the ratings agencies. The US credit rating would fall from AA+ to D. This would allow most bond-holders to demand immediate repayment. US bonds would become ineligible to numerous investment fund and other institutional investors.

Indirect Consequences

If the US chose to not repay its debts to China, everybody else would start thinking about the likelihood that the same could happen to themselves a few years later. Unless they think that the situation with China were singular, they would try to minimize their exposure and require a risk premium.

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  • Other commenters have pointed out that China could confiscate all sorts of US property which is physically within China. – user253751 May 2 at 12:31
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For some more context, it seems that the US would have difficulty targeting China specifically with this specific measure, cancelling just those bonds held by China. Even some of the proponents of such a measure admit that:

Cancelling Chinese-held U.S. debt could trigger severe disruption in the market for U.S. Treasuries, which could further undermine other financial markets.

In less hawkish/conservative circles, there's discussion whether such debt-cancelling threats are even constitutional, given the 14th Amendment of the US Constitution. Also note that Kudlow has denied that US administration is considering that move in particular:

Trump's top economic adviser denied the report. "The full faith and credit of U.S. debt obligations is sacrosanct. Period. Full stop," White House economic adviser Larry Kudlow told Reuters.

There are quite a few other measures the US could use to target China though and Trump said it's much easier for his administration to pursue those instead:

Asked whether he would consider having the United States stop payment of its debt obligations as a way to punish Beijing, Trump said: "Well, I can do it differently. I can do the same thing, but even for more money, just by putting on tariffs. So, I don't have to do that."

Also, if you want some kind of (smaller scale) example of what can happen if those potentially in the sights of such a measure (in the bond market) "smell it", Russia has unloaded practically all their US treasury bonds in 2018 (whether they had a justifiable intelligence reason to do this or not, who knows...)

The sudden debt dump may have contributed to a short-term spike in Treasury rates that spooked the market. 10-year Treasury yields topped 3% in April for the first time since 2014. [...]

Russia's selling has not hurt America's ability to borrow money. That's because investors -- particularly life insurers and pension funds that serve aging baby boomers -- have a big appetite for fixed income. Treasury rates quickly descended back below 3% because demand for bonds continued to grow.

The limited impact from Russia's selling makes sense. It's not a leading creditor of the United States. China is. Even at Russia's recent peak of $105.7 billion in November 2017, it only ranked as the 15th biggest foreign holder of US debt. China owns about $1.2 trillion -- or roughly 10 times as much as Russia.

But the bond market is just one side of this coin. Simultaneously, if China decided (for whatever reason) to dump US treasuries at massive scale, that would weaken the dollar, which would be a boost, temporarily at least, for US exports.

N.B. one less-than-completely-unrealistic way that the US could do this selective debt-cancelling, albeit not so overtly, is to allow lawsuits that seek to recover (from the PRC) the debt once issued by the Republic of China. These have been dismissed in the late 1970s by retroactive application of the Foreign Sovereign Immunities Act. It so happens that these debts (with interests and penalties) would amount about about $1T too. (That would probably require Congress cooperation, but here's some precedent with Congress amending FSIA for the purpose of allowing lawsuits against Saudi Arabia following 9/11.)

“I think everyone who works for Trump at the Treasury Department thinks this is loony,” says Mitu Gulati, law professor at Duke University and a sovereign-debt restructuring expert. “But I can’t help but be tickled pink, because at a legal level these are perfectly valid debts. However, you’ve got to get a really clever lawyer to activate them.” [...]

Gulati argues that this could perhaps be done—for instance, by arguing that China making payments on modern bonds violates pari pass[u] (equal payment) clauses embedded in the historic debt. Such clauses were successfully used by hedge funds seeking payment from Argentina a few years ago. It’s a legal long shot, but one that Gulati has assigned to his law students as a theoretical exercise. The U.S. Securities and Exchange Commission is studying the debt, too.

On the FSIA-amendment angle, there actually such proposals out already but these seem to have been made explicitly with reference to Covid-19 lawsuits (rather than recovering old RoC debt):

Another Missouri official, Republican Senator Josh Hawley, appears to have recognized that suits against China for damages caused by coronavirus cannot be brought in U.S. courts. He has proposed changing U.S. law to allow these claims (a move that would have disastrous foreign relations consequences). Another proposal by Republican Senators Marsha Blackburn and Martha McSally (the ‘‘Stop China-Originated Viral Infectious Diseases Act of 2020’’ or the ‘‘Stop COVID Act of 2020”), would create an exception to sovereign immunity where a foreign State is alleged “whether intentionally or unintentionally, to have discharged a biological weapon.” The text of a third proposed amendment to the FSIA introduced by Rep. Dan Crenshaw (R-Texas) and Senator Tom Cotton (R-Ark.) targets foreign States, but it unironically condemns those

responsible for, or complicit in ordering, controlling, or otherwise directing acts intended to deliberately conceal or distort the existence or nature of COVID-19, if such acts are found to have likely contributed to the global COVID-19 pandemic.

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  • "Kudlow has denied that US administration is considering that move" - neoliberals in the US will recognise the ideological implications of such cancellation, but as capitalism continues to falter (and has done for 50 years for the American worker), a radical politician may eventually decide that they cannot afford to maintain such ideological pretense. – Steve May 1 at 14:34
  • This answer should be the top answer, as it covers both the political consequences and the economic consequences in great detail – awsirkis May 1 at 22:59
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    @Steve it seems somewhat unfair to target the Chinese (and other bondholders) for the US's inability to live within its means and balance its budget, especially under a nominally small-government Rep administration. The fallout of such a move could, quite possibly, be such that the American worker would be considerably worse off after such a foot machine-gunning venture. It would be tempting to think it's just a rumor but given this POTUS, who knows. – Italian Philosophers 4 Monica May 1 at 23:00
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In addition to the very good answers above, one possibility is that China could attempt to take possession of US assets to which it has access, whether or not those assets were explicit collateral for the loans in question. This could easily include assets of US-owned private companies, or even of US citizens, within China or in countries in which it has influence.

Even imprisoning US citizens would not be beyond many observers' expectations. Two Canadians are being held in China, nominally on criminal charges but in reality certainly in retaliation for Canada's arrest, on US request, of Huawei executive Meng Wanzhou. (Since late 2018 she has been on house arrest in her own homes in Vancouver as her lawyers fight extradition to the US; the Canadians are in isolation in Chinese prisons). It would not be at all implausible to find US business travelers held on charges of violating some obscure import/export rule, or tourists held on manufactured drug charges.

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